FTZs offer trade solution

Foreign investors in China require a legal structure that allows them to import goods for re-sale in yuan because most of their Chinese customers do not have the rights to pay for the imported goods in foreign currency. Furthermore, it is beneficial if a foreign investor selling goods into China can maintain a stock in the country so that it may shorten the delivery time to customers and promote sales.

The current regulatory regime of foreign-invested trading and distribution activities does not support such a growth potential. Trading, distribution and after-sales services are restricted business sectors for foreign investors in China. Wholly foreign-owned trading companies are prohibited and so foreign investors must form joint ventures with Chinese partners before they can invest in this particular sector. Moreover, no majority foreign equity is allowed and there are various business scope and geographical limitations, as well as stringent entry prerequisites that need to be overcome.

A foreign-invested distribution centre is a legal entity that provides a comprehensive distribution system using its own warehousing facilities to store spare parts or finished products for distribution to manufacturers, second-tier wholesalers or retailers. However, at present such centres are only allowed in the 15 designated free trade zones (FTZs).

Legal framework
Foreign investors can set up wholly owned distribution centres in any one of the FTZs, selling imported or locally sourced goods to customers inside and outside the FTZ. Sales to customers outside the FTZ who do not have import rights can be conducted through a bonded exchange in Shanghai Waigaoqiao or Shenzhen Futian FTZ, which provide customs clearance services and issuance of VAT invoices in yuan for a handling commission. In Guangzhou FTZ, a distribution centre needs to engage an import/export agent to handle customs clearance for imported goods and to seek the State Taxation Bureau's approval for issuing VAT invoices for selling domestically sourced goods to Chinese customers outside the FTZ.

The typical permitted business scope of a distribution centre would include international trade, entrepreneurial trade, trade among enterprises established in the FTZ, acting as trade agency within the FTZ, simple processing and packaging, product exhibition, technical consulting services and after-sale services? Like all other wholly foreign-owned enterprises, a distribution centre does not have domestic trade included in its permitted business scope. Sales to Chinese customers outside the FTZ are rationalised by the customers, clearance and VAT invoicing mechanism. Nevertheless, there is a technical risk that the domestic trading activities may be challenged by the State Administration of Industry and Commerce.

Following recently introduced legislation, FTZ distribution centres are now allowed to set up liaison offices outside FTZs. This would give them more access to wholesalers, retailers and key accounts for sales and after sales functions.

FTZ distribution centres would enjoy the following customs preferential treatment: the import duty and VAT on goods physically imported into the FTZ would be deferred until the goods enter a non-FTZ area of China. In this regard, the cashflow position and stock holding cost could be improved quite significantly; sales of goods by the distribution centre to other companies within the FTZ are exempt from import duty and VAT; and the machinery and equipment for the distribution centres? own use could be exempt from import duty and VAT.

In Guangzhou FTZ, multinational companies, large-scale distribution centres and companies with good customs compliance records would enjoy fast and simple procedures in customs clearance and settlement. Distribution centres here can also apply to clear customs and settle the import duty and VAT on a periodical basis. This means that customs clearance does not have to be performed each time goods are delivered to customers outside the FTZ; instead, customs clearance for a number of transactions could be applied for collectively during a prescribed time interval, say monthly. This arrangement could streamline the distribution and after sales services by minimising the delivery lead-time to customers and again improve the cashflow position of the distribution centre.

The standard income tax rate for foreigninvested joint venture trading companies in China is 33 percent. In FTZs, a preferential income tax rate of 15 percent is generally applied to all foreign-invested distribution centres. Moreover, in Guangzhou FTZ, distribution centres could be entitled to a special income tax refund, which is equivalent to a certain percentage (60 percent for the first year, 50 percent for the second year and 30 percent for the third year) of the income tax payment that is retained by the zone.

Prospects in the post-WTO era
Upon China's accession to the WTO, import rights were granted to all domestic enterprises over a period of three years. Within one year of China's accession, before December 11, 2002, foreign investors will be able to establish joint ventures (with some geographic restrictions) to distribute goods on a wholesale level, either as a principal or as an agent. Within two years of accession, foreign investors will be able to own a majority interest in these distribution joint ventures with no geographic restrictions, and a year later they will be able to establish wholly owned subsidiaries to engage in wholesaling in China. Existing foreign investment enterprises will be given import rights, for example to import finished goods for resale, using the same timetable. They will also be able to distribute locally sourced goods.

In other words, wholly foreign-owned distribution centres could be established in any part of China by 2004. By then, foreign investors may consider relocating their FTZ distribution centres to a downtown location that is closer to their wholesalers, retailers and key accounts. Alternatively, they could be retained because of the better-developed ports and logistics facilities of the FTZs and the various customs and tax incentives offered by FTZs. In any case, most foreign investors would prefer to adopt an interim solution for an effective management of their distribution services during the market phase-in period in order to capture the biggest market share. Bearing this in mind, a wholly foreign-owned FTZ distribution centre could be a very attractive trading structure for foreign investors in China before 2004.

This article was written by Charles Leung, partner and Peggy Lue, senior manager of PricewaterhouseCoopers Ltd Guangzhou.

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